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Chapter 23 DEBT ANALYSIS AND MANAGEMENT

Chapter 23 DEBT ANALYSIS AND MANAGEMENT.  Centre for Financial Management , Bangalore. OUTLINE Growing Interest in Debt Risk in Debt Rating of Debt Securities Design of Debt Issues Innovations in Debt Securities Securitisation Bond Covenants Bond Refunding Duration

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Chapter 23 DEBT ANALYSIS AND MANAGEMENT

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  1. Chapter 23 DEBT ANALYSIS AND MANAGEMENT  Centre for Financial Management , Bangalore

  2. OUTLINE • Growing Interest in Debt • Risk in Debt • Rating of Debt Securities • Design of Debt Issues • Innovations in Debt Securities • Securitisation • Bond Covenants • Bond Refunding • Duration • Term Structure of Interest Rates • Explaining the Term Structure  Centre for Financial Management , Bangalore

  3. GROWING INTEREST IN DEBT • Lesser support in the form of term loans • Complete freedom in designing debt instruments • Credit rating agencies • ‘Wholesale Debt Market’ segment • Massive investments in infrastructure • Volatility of equity market  Centre for Financial Management , Bangalore

  4. RISK IN DEBT • Interest rate risk • Inflation risk • Real interest rate risk • Default risk • Reinvestment risk • Foreign exchange risk  Centre for Financial Management , Bangalore

  5. DEBT RATING A debt rating essentially reflects the probability of timely payment of interest and principal by the borrower.  Centre for Financial Management , Bangalore

  6. FUNCTIONS OF DEBT RATINGS • (OR DEBT RATING FIRMS) • Provide superior information. • Offer low-cost information. • Serve as a basis for a proper risk-return tradeoff. • Impose a healthy discipline on corporate borrowers. • Lend greater credence to financial and other representations. • Facilitate the formulation of public policy guidelines on • institutional investment.  Centre for Financial Management , Bangalore

  7. RATING METHODOLOGY • Two broad types of analyses are done: (i) industry • and business analysis, and (ii) financial analysis • Subjective judgment often plays an important role. • Industry risk characteristics are likely to set the • upper limit on rating.  Centre for Financial Management , Bangalore

  8. CRISIL DEBENTURE RATING SYMBOLS AAA Highest safety AA High safety A Adequate safety BBB Sufficient safety BB Inadequate safety B Susceptible to default C Vulnerable to default D In default  Centre for Financial Management , Bangalore

  9. DESIGN OF DEBT ISSUES • Maturity period • Fixed versus floating rate • Sinking fund • Options  Centre for Financial Management , Bangalore

  10. INNOVATIONS IN DEBT SECURITIES • Deep discount bonds • Floating rate bonds • Commodity – linked bonds • Bonds with embedded options • Extendable bonds • Structured notes • Inverse floaters • Junk bonds  Centre for Financial Management , Bangalore

  11. SOURCES OF VALUE  Centre for Financial Management , Bangalore

  12. SECURITISATION • Securitisation involves packaging a designated pool of • assets (mortgage loans, consumer loans, hire purchase • receivables, and so on) and issuing securities which are • collateralised by the underlying assets and their • associated cash flow stream. • Securities backed by mortgage loans are referred to as • mortgage backed securities; securities backed by other • assets are called asset based securities.  Centre for Financial Management , Bangalore

  13. KEY STEPS IN SECURITISATION • Seasoning • Credit enhancement • Transfer to a special purpose vehicle (SPV) • Issuance of securities  Centre for Financial Management , Bangalore

  14. SECURITIES The SPV, usually organised as a Trust, issues securities backed by the pool of assets held by it. These securities are called Pass Through Certificates (PTCs) because the cash flows received from the pool of assets are transmitted (passed) to the holders of these securities on a pro-rata basis after deduction of service fee  Centre for Financial Management , Bangalore

  15. SECURITIES There may be one or more classes of PTCs with differing priorities. Where there are two or more classes of PTCs, the rules for the distribution of interest and principal repayments, derived from the underlying pool of assets, among different classes of PTC holders are specified upfront.  Centre for Financial Management , Bangalore

  16. WAYS IN WHICH SHAREHOLDERS AND THEIR AGENT-MANAGERS CAN HURT BONDHOLDERS • Dividend payment • Claim dilution • Asset substitution • Underinvestment  Centre for Financial Management , Bangalore

  17. POSITIVE BOND COVENANTS • A positive (or affirmative) covenant states what the borrowing firm should do during the term of the loan (bond). Here are some examples of positive covenants: • The firm has to periodically furnish certain reports • and financial statements to the lenders. • The firm agrees to maintain a certain working • capital. • The firm agrees to set up a sinking fund for • redemption of debt. • The firm has to maintain a certain net worth. • The firm has to mortgage its assets.  Centre for Financial Management , Bangalore

  18. NEGATIVE BOND COVENANTS • A negative covenant prohibits or restricts certain actions by the borrowing firm, unless the same are approved by the prior permission of the lender. Here are some typical negative covenants: • The firm cannot raise additional long-term debt. • The firm cannot undertake a diversification project or • acquire another firm or merge with another firm. • The firm may not dispose or lease its major assets. • The firm may not pay dividends in excess of a certain • percentage.  Centre for Financial Management , Bangalore

  19. BOND-REFUNDING DECISION The bond-refunding decision should be analysed the way any other capital budgeting decision is analysed. Hence, the decision rule is: Refund the bond if the present value of the stream of net cash savings is greater than the initial cash outlay.  Centre for Financial Management , Bangalore

  20. INITIAL OUTLAY Initial outlay = The terms on the right-hand side of the above expression are defined as follows: Cost of calling the old bonds = Face value of the bonds + Call premium Net proceeds of the new issue = Gross proceeds – Floatation costs (issue expense + discount) = Tax rate Cost of calling the old bonds Net proceeds of the new issue Tax savings on tax- deductible expenses – – Call premium + Unamortised floatation costs on the old bond issue Tax savings on tax- deductible expenses  Centre for Financial Management , Bangalore

  21. ANNUAL NET CASH SAVINGS Annual net cash savings = The terms on the right-hand side of the above expression are defined below: Annual net cash outflow on new bonds Annual net cash outflow on old bonds – Tax saving on interest expense and amortisation of floatation cost - = Annual net cash outflow on old bonds Interest expense Tax saving on interest expense and amortisation of issue cost Annual net cash outflow on new bonds Interest expense = –  Centre for Financial Management , Bangalore

  22. ILLUSTRATION To illustrate how the bond-refunding decision should be analysed, let us consider an example. Acme Chemicals has Rs.100 million, 18 percent bonds outstanding with 10 years remaining to maturity. As interest rates have fallen, Acme can refund these bonds with a Rs.100 million issue of 10-year bonds carrying a coupon rate of 16 percent. The call premium will be 5 percent. The issue costs on the new bonds will be Rs.5 million. The unamortised portion of the issue costs on the old bonds is Rs.3 million and this can be written off no sooner the old bonds are called. Acme's marginal tax rate is 40 percent.  Centre for Financial Management , Bangalore

  23. ILLUSTRATION The bond-refunding decision may be analysed as follows: 1. Initial Outlay (a) Cost of calling the old bonds Face value of the old bonds 100,000,000 + Call premium + 5,000,000 105,000,000 (b) Net proceeds of the new issue Gross proceeds 100,000,000 – Issue costs – 5,000,000 95,000,000 (c) Tax savings on tax-deductible expenses Tax rate [Call premium + Unamortised issue costs on the old bond issue] 0.4[5,000,000 + 3,000,000] 3,200,000 Initial Outlay : 1 (a) – 1 (b) – 1 (c) 6,800,000

  24. ILLUSTRATION • Annual Net Cash Savings • (a) Annual net cash outflow on old bonds • Interest expense 18,000,000 • - Tax savings on interest expense and • amortisation of issue costs • 0.4 [18,000,000 + 300,000/10] - 7,320,000 • 10,680,000 • (b) Annual net cash outflow on new bonds • Interests expense 16,000,000 • - Tax saving on interest expense and amortisation • of issue cost 0.4 [16,000,000 + 5,000,000/10] 6,600,000 • 9,400,000 • Annual net cash savings: 2 (a) – 2(b) 1,280,000  Centre for Financial Management , Bangalore

  25. ILLUSTRATION 3. Present Value of the Annual Cash Savings Present value of a 10-year annuity of 1,280,000 using a discount rate of 9.6 percent after-tax cost of new bonds 8,002,560 (1,280,000 x 6.252) 4. Net Present Value of Refunding the Bonds (a) Present value of annual cash savings 8,002,560 (b) Net initial outlay 6,800,000 (c) Net present value of refunding the bonds 1,202,560  Centre for Financial Management , Bangalore

  26. DURATION The duration of a bond is the weighted average maturity of its cash flow stream, where the weights are proportional to the present value of cash flows. Formally, it is defined as: Duration = [PV(C1) x 1 + PV(C2) x 2 + … + PV(Cn) x n] / V0 (23.3) where PV(Ct) = present value of the cash flow receivable at the end of year t (t = 1, 2, ... , n) V0 = current value of the bond For calculating the present value of cash flow, the yield to maturity (the internal rate of return) of the bond issue is used as the discount rate. The duration of a bond, in effect, represents the length of time that elapses before the "average" rupee of present value from the bond is received.  Centre for Financial Management , Bangalore

  27. DURATION - 2 TO ILLUSTRATE HOW DURATION IS CALCULATED CONSIDER BOND A. BOND AFACE VALUE RS 100COUPON (INTEREST RATE) 15 PERCNET PAYABLE ANNUALLYYEARS TO MATURITY 6REDEMPTION VALUE RS 100CURRENT MARKET PRICE RS 89.50YIELD TO MATURITY 18 PERCENT CALCULATION OF DURATION

  28. CHARACTERISTICS OF DURATION • The following characteristics of duration are worth noting: • For a zero coupon bond, the duration is simply equal to • the maturity of the bond. • Other things being equal, the higher the interest (coupon • rate), the shorter the duration. • Other things being equal, the higher the yield to maturity, • the shorter the duration. This is so because in this case • the present value of nearer payments is more important • vis-à-vis the present value of more distant payments.  Centre for Financial Management , Bangalore

  29. DURATION AND IMMUNISATION - 1 CAPITAL VALUE INTEREST RATE RETURN ON RE- INVESTMENT OF INTEREST CAPITAL VALUE INTEREST RATE RETURN ON RE- INVESTMENT OF INTEREST FOR IMMUNISATION SET DURATION EQUAL TO INVESTMENT HORIZON

  30. THE YIELD CURVE THE YIELD CURVE., OR THE TERM STRUCTURE OF INTEREST RATES, SHOWS HOW YTM IS RELATED TO TERM TO MATURITY FOR BONDS THAT ARE SIMILAR IN ALL RESPECTS, EXCEPTING MATURITY. YIELD CURVE YIELD TO MATURITY (YTM) 14.0 13.0 12.0 1 2 3 4 5 TERM TO MATURITY (YRS)

  31. TYPES OF YIELD CURVEYTM A. UPWARD SLOPINGYTM B. DOWNWARD SLOPING TERM TERM YTM C. FLAT YTM D. HUMPED TERM TERM  Centre for Financial Management , Bangalore

  32. ILLUSTRATIVE DATA FOR GOVERNEMNT SECURITIES Face Value Interest Rate Maturity (years) Current Price Yield to maturity 100,000 0 1 88,968 12.40 100,000 12.75 2 99,367 13.13 100,000 13.50 3 100,352 13.35 100,000 13.50 4 99,706 13.60 100,000 13.75 5 99,484 13.90  Centre for Financial Management , Bangalore

  33. FORWARD RATES 88968100000 • ONE - YEAR TB RATE 100000 88968 = r1 = 0.124 (1 + r1) • 2 - YEAR GOVT. SECURITY 12750 112750 99367 = + + r2 = 0.1289 (1.124) (1.124) (1 + r2) • 3 - YEAR GOVT. SECURITY 13500 13500 113500 100352 = + + (1.124) (1.124) (1 .1289) (1.124) (1.1289) (1 + r3) r3 = 0.1512

  34. FORWARD RATES • 4-YEAR GOVERNMENT SECURITY  Centre for Financial Management , Bangalore

  35. FORWARD RATES  Centre for Financial Management , Bangalore

  36. EXPLAINING THE TERM STRUCTURE • EXPECTATIONS THEORY • LIQUIDITY PREFERENCE THEORY • PREFERRED HABITAT THEORY • MARKET SEGMENTATION THEORY  Centre for Financial Management , Bangalore

  37. EXPECTATIONS THEORY SHAPE …. YIELD CURVE … DEPENDS ON .. EXPECTATIONS … THOSE WHO PARTICIPATE … MARKET (1 + tRn) = [ (1 + tR1) (1 + t+1R1) … (1 + t+n-1Rn)]1/n YIELD CURVE EXPLANATION ASCENDING SHORT-TERM RATES RISE IN FUTURE DESCENDING SHORT-TERM RATES … FALL IN FUTURE HUMPED SHORT-TERM RATES … RISE …. FALL FLAT SHORT-TERM RATES . . UNCHANGED IN FUTURE  Centre for Financial Management , Bangalore

  38. LIQUIDITY PREFERENCE THEORY FORWARD RATES SHOULD INCORPORATE INTEREST RATE EXPECTATIONS AS WELL AS A RISK (OR LIQUIDITY) PREMIUM (1 + tRn) = [ (1 + tR1) (1 + t+1R1+L2) … (1 + t+n-1Rn +Ln)]1/n AN UPWARD-SLOPING YIELD CURVE SUGGESTS THAT FUTURE INTEREST RATES WILL RISE (OR WILL BE FLAT) OR EVEN FALL IF THE LIQUIDITY PREMIUM INCREASES FAST ENOUGH TO COMPENSATE FOR THE DECLINE IN THE FUTURE INTEREST RATES  Centre for Financial Management , Bangalore

  39. PREFERRED HABITAT THEORY INVESTORS PREFER TO MATCH THE MATURITY OF INVESTMENT TO THEIR INVESTMENT OBJECTIVE BORROWERS . . TOO IF MISMATCH … INDUCEMENT TO SHIFT MARKET SEGMENTATION THEORY EXTREME FORM OF PREFERRED HABITAT THEORY  Centre for Financial Management , Bangalore

  40. SUMMING UP • The market for debt is poised for substantial growth. • Debt instruments are subject to diverse risks • A debt rating reflects the probability of timely payment of • interest and principal. • A wide range of innovative debt instruments have been • created, particularly from the middle of 1970s. • Innovative debt instruments add value in one or more of the • following ways : risk reallocation/yield reduction, lower • issuance cost, tax arbitrage, reduced agency cost, and enhanced • liquidity • To protect their interest, bondholders ask for several • covenants, positive as well as negative.  Centre for Financial Management , Bangalore

  41. Refund a debt issue if the present value of the stream of net • cash savings is greater than the initial cash outlay. • The duration of a bond is the weighted average maturity of • its cash flow stream. • The volatility (or interest rate sensitivity) of a bond is related • to its duration as follows: Volatility = Duration/ (1+yield) • The term structure of interest rates, popularly called the • yield curve, shows how yield to maturity is related to term to • maturity. • Three principal explanations have been offered to explain the • term structure of interest rates: the expectations theory, the • liquidity preference theory, and the preferred habitat theory  Centre for Financial Management , Bangalore

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